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World Tour: Australia's Service Economy & Commodities

Beautiful Sydney, Australia combines the best parts of San Francisco, Seattle, and New York.

It's busy with new construction around every corner, and there's familiar brands including Oracle (NYSE: ORCL), IBM (NYSE: IBM), Caterpillar (NYSE: CAT), Boeing (NYSE: BA), McDonald's (NYSE: MCD), and privately held Subway—signs that U.S. multinationals continue to bank on growth in this old penal colony turned cosmopolitan hotspot and Asian commodities trading hub.

It's clear this natural resource stronghold is increasingly services oriented as it competes on the global economic stage. But do Australia's economic fortunes still largely rise and fall with commodities' supply and demand? You bet. And these are volatile times for commodities and the markets that rely on them.

Selling To Asia

Services account for about 70% of Australian gross domestic product, and the country's GDP is growing at a 2.3% clip so far this year, the Royal Bank of Australia says. The services sector accounts for about 75% of jobs. Of the 23.6 million people who call Australia home, 11.7 million are employed, according to government data, keeping the unemployment rate hovering around 6.2%.

But even services are hitched directly to commodities; much of the services sector supports Australia's industry sector, including mining, equipment, food, chemicals, and steel. Australia exports commodities like coal, iron ore, gold, meat, wool, alumina, and wheat primarily to trading partners in Asia. China accounts for a whopping 36% of Australian exports, and Japan takes another 18%, government data shows.

Hot Commodities Cool

The heavy dependence on commodities served Australia well in the early 2000s because prices were booming. Remember the peak in oil, and gold at $1,900 an ounce? The boom helped the Australian economy grow aggressively, and its stock market performed relatively well during this period. But these once-hot commodities have cooled in recent years (figure 1).

The drop in commodities prices was caused by a number of factors. With hindsight, it's easy to see the huge buildup in the supply of crude oil owed to new drilling technologies. New mines opened, and the supply of gold, iron ore, and other metals swelled. More recently, demand for commodities in Asia has slowed as Chinese growth projections were downgraded. What's more, the surging U.S. dollar has hurt commodity prices. For instance, the big leg lower in the CRB Index in late 2014 coincided with a big move higher in the U.S. dollar.

As of this writing, global commodities were taking another beating. Anticipation of a U.S. interest rate hike and the related U.S. dollar's strength—as well as soft global growth and a supply glut—weighed on demand for raw materials. Gold in late July fell for some 10 days in a row before a brief respite, logging its steepest drop in almost two years and moving below $1,100 an ounce. Crude futures were also heading south, trading near $50 a barrel depending on the futures market used for reference.

Commodity Slump Pressures Stocks

The slump in commodities has contributed to a poor relative performance in the Australian stock market compared with other developed markets. Surprisingly, the Australian stock market hasn't gotten back to its pre-financial crisis levels from 2007, while the stock markets of many other developed economies have exceeded these levels (figure 2).

FIGURE 2: GERMAN LEADERSHIP? This chart compares the performance since 2007 of a U.S. stock market (S&P 500) in red, German (DAX) in brown, and Australian (ASX 200) in blue. Source: Yahoo Finance. For illustrative purposes only. Past performance does not guarantee future results.

Despite the underperformance of the Australian stock market compared with the U.S. and Germany, valuations down under are, well, average, according to most analysts.

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